USDJPY and Stock Indices Correlation

 Correlation Between USDJPY and Stock Indices

Historically, the American indices (S&P 500, DJIA, NASDAQ) are trading in the same direction with USD/JPY (the American Dollar against the Japanese Yen).

Defining Correlation:

In general, a correlation between two variables expresses an average relationship that is backed with historical data. The correlation coefficient receives values between -1.0 and +1.0, and that means:

• +1.0 is the perfect correlation reflecting identical movements / directions

• -1.0 is the perfect negative coefficient reflecting identical opposite directions

US Dollar Correlation Coefficient

By comparing USDX (US Dollar Index) against Dow Jones industrial in the past 20 years we get a correlation coefficient around +0.35. That positive relation (+) means that the US Dollar and DJIA move generally in the same direction. On the other hand, as the correlation coefficient is only 0.35, only 35% of all DJIA movements are linked to the US Dollar movements.

There is a good reason for that.

As the demand for American stocks increases the demand for US Dollars increases too, as US Dollars are needed in order US stocks to be purchased. Below we are going to see why the Forex pair USDJPY is more correlated to US equities than any other pair.

USDJPY and American Stock Indices Relationship

The correlation between American Indices and the US Dollar is so powerful that some investors see Dow Jones Industrial as a USD market sentiment indicator.

That relationship can be explained, and here is how.

Explanation:

When investors want to buy US stocks they tend to borrow money in low-interest-rate currencies, such as the Japanese Yen. The Japanese Yen and the Swiss Franc are perfect for that job. So let's see closer an example of this transaction:

(1) The investors feel bullish about the market so they borrow money in order to buy stocks. They borrow money in Japanese Yen, as Yen offers traditionally very low-interest rates. After they borrow in Yen they change that money to US Dollars in order to buy US stocks. Therefore, they buy US Dollars today and repay that money in the Japanese Yen in the future. That transaction is pushing USDJPY higher.

(2) The investors now feel bearish about the market so they want to sell stocks. They are selling the stocks they bought before in US Dollars and pay back the money they have borrowed in Japanese Yen. Therefore, they exchange US Dollars to pay back Yen. That transaction is pushing USDJPY lower.

Note that as financial arbitrage gets involved, the above process is accelerated and happens very quickly. Hence, arbitrage creates a direct correlation between USDJPY and American stocks.

Chart: An amazing intraday correlation that occurred in early January 2016

USDJPY and NIKKEI

It is interesting that before the 2007 crises USDJPY and Nikkei were inversely correlated. After 2007, the global stock markets operate as a common pool of risks and opportunities, hence, the Nikkei is correlated to DJIA which is in turn correlated to USDJPY. Therefore, after 2007, Nikkei, and USDJPY are positively correlated.

Conclusions

The correlation between Dow Jones Industrial and USDJPY is strong, but the relationship between equities and currencies is a little bit more complicated. This relationship may change from time to time depending on several variables, including the level of interest rates, corporate earnings, global conditions, etc. As you can see in the following chart there are long periods when USDJPY and Dow Jones are moving in the same direction but also smaller periods of time when they move in opposite directions.

Chart: Historical Correlation Between USDJPY and Dow Jones Industrial

Source: ForexExperts.net, Google Finance

■ Correlation Between USDJPY and Dow Jones Industrial

ForexExperts.net